(FORTUNE Magazine) - San Diego: Since opening in October, The Point 92103, a 48-unit condo, had sold a meager two apartments. The developers cut the list price on a one bedroom from $349,000 to as low as $299,900 and lured outside brokers with rich 5% commissions. So far the moves have led to just one sale.

Suburban Washington, D.C.: Brookfield Homes told Lisa Hufford that a six-bedroom colonial would cost $788,000. She started bargaining and got Brookfield to drop the price by $30,000, pay $5,000 toward her closing costs, and throw in a $14,500 finished basement.

Suburban Boston: Last year Vu and Simone Le asked $1.23 million for their 1935 Victorian in Swampscott. Best offer: $951,000. In March they gave up. "We didn't catch the wave," says Vu. "It's a buyer's market."

The stories keep piling up. In many once-sizzling markets around the country, accounts like these have replaced tales of waiting lists for unbuilt condos and bidding wars over humdrum three-bedroom colonials.

The message is clear. Five years of superheated price gains rescued America from stock market collapse, put billions in consumers' pockets, and ignited a building boom that bolstered the nation's economy. (To relive the frenzy, see "Riding the Boom" on fortune.com.) But it's over. The great housing bubble has finally started to deflate.

You won't find that news in broad national statistics or the upbeat comments from the real estate industry. The latest official figures, for example, show both new and existing home sales rising in March, a mixed bag on prices--and a record number of new homes on the market.

But FORTUNE's on-the-ground reporting--in what up to now have been some of the nation's hottest areas--paints a very different picture: Contracts are being canceled, deals are drying up, prices are starting to drop. The psychology is shifting even as thousands of new homes and condos join the for-sale listings each day--so the downward pressure will only get worse. "The buyers' sense of urgency is gone," says Bob Toll, CEO of luxury builder Toll Brothers (Research), who has long been a housing bull. "They see the market going soft, so they stall."

Take a deep breath.

We're not forecasting a nationwide housing collapse. For one thing, the vast expanse of America between the coasts was never touched by real estate mania and is in no danger of a meltdown. And even some overheated markets--including Manhattan, Los Angeles, and California's Orange County--are still simmering.

But things are suddenly looking very chilly indeed in four coastal cities--Boston, Washington, Miami, and San Diego--as well as three Western boomtowns: Phoenix, Las Vegas, and Sacramento. So far this year, monthly sales have fallen 11% to 25% in Miami, Boston, northern Virginia, and San Diego, according to local housing experts.

The prognosis is even worse in Phoenix, where only 4,500 homes sold in the first three months of 2006, vs. 6,100 for the same period last year, and in Sacramento, where new-home sales plunged 57% in the first quarter (compared with the first quarter of 2005). In California it now takes six months to sell a house, twice as long as a year ago.

And what's happening in these areas is a sign of what may be coming in the rest of the bubble zone--the two dozen or so mainly coastal cities and their suburbs that have seen prices soar in recent years and account for 60% of the nation's residential real estate value.

The problem is as basic as beams and trusses: The triple threat of soaring prices, higher mortgage rates, and relentlessly rising property taxes has drastically increased the cost of ownership and put many homes out of reach for a huge number of potential buyers.

In California, for example, only one household in seven can manage the payments on the median-priced house, now selling for $561,000. It takes an income of $134,000 to afford that home, which might be a modest three-bedroom ranch in a bland subdivision. The affordability gap is driving buyers to the sidelines, replacing the frenzy with a growing void as buyers wait for prices to drop.

With houses hovering beyond the reach of most potential purchasers, formerly frantic markets grow eerily calm. People who rush to list their homes, hoping to grab a fat gain just before prices break, take them off the market. Sales shrink as buyers float low-ball offers, and sellers refuse them. Realtors and mortgage brokers find other jobs. The bubble areas turn into Dead Zones.

There's no mystery about what it will take to close the affordability gap and bring the markets back to life: Prices will have to come down, and incomes will have to move up.

Right now the ratio of home values to incomes in the bubble zones is about 40% above its historical average. So the only question is how much of the adjustment will come from rising incomes and how much from falling prices. On that point there's reason to be hopeful.

In the past, housing declines almost invariably occurred while the economy was suffering through a recession. This time the housing downturn is coming during a period of strength, with GDP surging nearly 5% in the first quarter. If the economy keeps chugging along, household incomes should grow at around 4% a year. Under those conditions one likely scenario is that housing prices would drop 10% to 15% in the bubble zone over the next 12 months, then remain flat for maybe four more years while incomes catch up.

But there's another possibility. For the past few years the housing boom has driven the economy, adding jobs in construction, remodeling, and real estate services. And consumers gorged on the equity in their homes, taking out a total of $2 trillion via loans, refinancings, and sales over the past five years. Those powerful stimulants, which added a full point to annual GDP growth, will soon vanish.

If corporate spending or some other force doesn't come along to pick up the slack, we could go into a recession that would cut income growth to zero. Then inflated housing prices would have to shoulder the entire, wrenching adjustment, falling 30% or more over several years.

In either case, many individual homeowners have nothing to worry about: They can simply stay put and ride out the cycle. The only thing they'll lose is the opportunity to brag about their paper profits. And in some places, appreciation has been so sharp that a seller could see prices plunge 30% and still make a hefty gain. The real losers will be those who bought recently at inflated prices and are forced to sell, usually because they're taking a job in another city or can't make the payments when their adjustable mortgage rate jumps. And speculators who bought overpriced condos in hope of a quick killing are going to get hosed.

The sudden shift in the nation's housing markets is exploding some long-held beliefs. The first is that a scarcity of buildable land on the coasts keeps a cap on supply and prevents prices from falling. But high prices inevitably work their magic, encouraging more people to sell existing homes and sparking new construction. Sure enough, prices are already tumbling in Boston, where a swarm of downtown condos is swelling the number of properties for sale and punishing the price of all housing.

A second myth is that today's big homebuilders learned their lesson in past downturns and now launch projects only when they have firm buyers lined up. But housing starts are still running at near-record levels of some two million units a year. Big builders, notablyD.R. Horton (Research) and Pulte Homes (Research), are starting 20% to 30% of their units on spec, without signing up buyers in advance. Risky move.

A third tenet holds that home values never drop in areas where employment is rising. But today some of the hardest-hit regions rank among the strongest job machines, notably northern Virginia and San Diego. The reason: Young buyers filling those jobs can't afford the houses for sale.

The current boom has spawned one new myth of its own: Hot markets will glide to a soft landing.

The National Association of Realtors and the National Association of Home Builders argue that housing is simply returning to "balance" and that prices across the country will resume "normal" increases of 4% to 6% this year and next.

"It's a good sign to see home sales holding close to the level of a strong rebound in the month before," said David Lereah, the NAR's chief economist, in a statement accompanying the latest data. "This is additional evidence that we're experiencing a soft landing." But the housing bulls are relying on wishful thinking. The total inventory of homes for sale, new and existing, stands at a staggering 3.8 million units, 70% higher than in 1999. The modest price increases they are predicting would make today's houses more unaffordable, adding to the already huge supply of unsold units and forcing an even more severe adjustment in the future.

To understand why prices became so unhinged, it's worth revisiting the extraordinary policies that inflated the bubble. In the aftermath of the stock market crash of 2000, Federal Reserve Board chairman Alan Greenspan feared that the huge, sudden loss of wealth could throw America into a severe recession.

To spark the economy, he cut the Fed funds rate from 6.5% in late 2000 to 1% by mid-2003. The impact on mortgages was profound. The rate on 30-year fixed-rate loans, the most popular type, plummeted to a 50-year low of 5.1%. The monthly payment on a $250,000 mortgage dropped to $1,350.

Cheap money turned the real estate boom into a frenzy. In the coastal cities, homes were already expensive by 2001, having appreciated by 65% or so since the early 1990s. Between 2000 and 2005, prices in most hot markets--Miami, San Diego, and the like--soared by 55% to 100% (on top of inflation).

Trying to keep pace, buyers increasingly resorted to riskier loans to lower monthly payments. Two types became the rage: adjustable-rate mortgages and exotics.

Homeowners who took out ARMs in 2003 or 2004 started with extremely low rates--at one point lenders were offering one-year adjustables with initial rates of as little as 3.5%. But many borrowers will face much higher monthly payments as the loans adjust.

A second, even more dangerous category is the exotic loan. The most extreme example--a true symbol of the bubble--is the negative-amortization loan, which allows borrowers to pay less than the interest due. The unpaid interest is tacked onto the principal, so the size of the loan grows every month. In 2004 and 2005 no less than 75% of all mortgages issued in the hot markets were either ARMs or exotic loans, compared with 20% in the late 1990s.

By mid-2004, with inflation looming and demand for capital growing, the Fed started raising rates. But Greenspan's gambit had started a speculative rampage that took on a life of its own. Homes had become America's investment vehicle of choice. Prices became totally detached from the fundamentals--chiefly rents and incomes--which were growing only modestly. It couldn't last.

The most troubled sector, the one that will fall first and fastest, is the condominium market. Typically cheaper than houses and easier to buy, sell, or rent out, condos are catnip for investors.

"I estimate that 80% of the sales in Miami went to investors at the peak of the market," says Lewis Goodkin, a consultant to condo developers. The problem is that investors tend to bolt when trouble looms. Gary Bahadur, 32, who owns a computer networking company in Los Angeles, bought six condos in California over the past few years. Now he's putting them all up for sale. "I'm getting out of California because it's topped out," he says, "The prices are so high that investors can no longer buy a condo and rent it to cover the mortgage."

Yet even as speculators flee, developers keep throwing up condos at a breakneck pace, in part because if they have already bought the land and poured the foundation, they have no choice but to finish the project. Unsold condos are piling up. In the Miami area 25,000 new units are under construction, and another 25,000 are approved. Yet the Miami market absorbed only 10,500 new condos in the past decade.

Tanya Wagner, a South African who worked as a food and beverage manager at the Four Seasons hotel, is caught in the squeeze. She paid $335,000 for a two-bedroom condo when she moved to Miami in 2004. Now she wants to start her own consulting business in Europe. In November she put her unit on the market for $485,000, the price that apartments in her building had sold for a few months earlier. But Wagner missed the peak. She's now dropped her price to $415,000, and she still hasn't had an offer. Holding the unit and renting it out doesn't appeal to her. "My belief is that prices will drop even more," she says.

When two-bedroom condos get discounted from $350,000 to $300,000, developers in the neighborhood drop their prices on $400,000 starter homes. Builders don't have the luxury of waiting out a slump; they need to sell for what they can get. At first they hold the line on base prices by offering incentives, from free pools to flat-screen TVs. Then, as unsold units collect, they move merchandise with huge discounts.

Builders also pitch in when potential customers are having trouble unloading their current home. A typical example is the help Pedro Kritselis is getting. He had to sell his house to afford to buy a new one in Bristow, Va. But the market is so soft that he couldn't get the price he needed, so he told the builder he'd have to walk away. To keep the sale, the developer shaved $25,000 from the price of the new house. That enabled Kritselis to sell his house for $25,000 less and still afford the new home.

One northern Virginia realtor is doing good business assisting homebuyers who need to sell a house to buy a new one. Ashley Leigh, among the region's most successful independent brokers, offers the following deal: If he can't sell the old house in 120 days, he'll buy it himself at a fixed price. Leigh is trumpeting the guarantee in an ad that appears on area billboards and grocery carts at the local Safeway. These days his services are a godsend to developers.

When they get customers who want to buy but need a minimum price for their existing house, the builders call Leigh. In return, he typically gets a 3% commission from the developer on the new sale and an exclusive listing on the old house that gives him a minimum of 3% on that sale. So far he has granted over 100 guarantees and been forced to buy ten houses himself. Even when he sells them at a small loss, he still makes money overall. "I have the cushion of the commission on both ends," he says. "On houses priced $600,000 or more, I make the guarantee less than today's market price, because I'm pretty sure prices will be lower when I sell."

Most homeowners don't have to sell; the new, lower prices will be set by those who have to bail out. They include not just investors but also owners who stretched their finances to buy a house. This year no less than 22% of Americans' $8.7 trillion in mortgages will reset rates--and the extra burden will be big. A typical three-year ARM will go from 3.6% to 5.6%, forcing a borrower with a $500,000 mortgage to pay an extra $800 a month in interest. Delinquencies are already rising rapidly. Since early 2005 delinquency rates have jumped almost 14%, to 2.5% for prime mortgage loans. "The banks will be forced to take back a lot of properties and sell them for the amount of the loan," says Mark Zandi of Moody's Economy.com. "That will add to the already huge supply on the market."

As painful as it may be for many people, the looming correction may turn out to be welcome news for house-hungry Americans. Young couples now priced out of the market will once again be able to buy a ranch or colonial without forking over half their income for mortgage payments. Growing families will be able to trade up for more living space without raiding the kids' college funds. Lauris Lambergs and his wife, Ginta, want to move from a condo in South Boston to a single family home. But until recently they were appalled at the exorbitant prices. Suddenly the power is shifting to the shoppers, and the Lambergs love it. "Up until last summer, going back five years, it was a ridiculous seller's market," says Lauris. "Now the buyers have some leverage." The Lambergs relish spending Sundays house hunting. "When we go to open houses, we're the only ones all day!" exults Lauris. It's the bright side of our gloomy outlook: The bargains are coming.

Additional reporting by Matthew Boyle, Nadira A. Hira, Julie Schlosser, Christopher Tkaczyk and Jia Lynn Yang contributed to this article.